Nominal and market interest rates

Investors get regular interest payments on their bonds as long as they are not zero bonds. These payments are collateralized with interest coupons. A bond’s interest is called the nominal interest rate. The interest is paid out at fixed intervals, typically once a year. If an investor buys a bond from an issuer between two pay-out periods, the investor gets paid the accrued interest for the remaining time. When a bond is issued, its nominal interest rate aligns with the prevailing market rate. In contrast to the nominal rate of interest, the so-called market rate is determined every day, influenced by macroeconomic factors. Factors that impact the market rate include expectations regarding inflation and economic growth.

• Inflation
  If real purchasing power falls because of price increases, this generally leads to an increase in market interest rates since market participants expect the central bank to react by increasing benchmark rates. Rising market interest rates lead to falling bond prices.
• Economic growth
  When the economy grows, wages and salaries also tend to grow. If the wage increases lead to higher prices, inflation is usually the result, which causes bond prices to decline.

Price development

Bonds are traded on the exchange until they mature. A bond’s price changes constantly; it is determined based on supply and demand. The relationship between the nominal interest rate and the market rate is decisive in determining a bond’s price development. If the market rate rises, the bond’s price falls. The yield moves toward the market rate. In contrast, falling market rates lead to rising bond prices. Investors can use this circumstance to realize price gains when market rates fall. The investor can only realize the profit, however, when he sells the bond before its maturity.

Psychological factors

In the past, it has always been the case that investors tend to shift their money to “safe harbors” in times of economic crisis. A “safe harbor” generally is understood to mean bonds from a country that can service the debt in its outstanding bonds at any time. The increase in demand has a positive effect on bond prices.

Tax aspects related to bond investments

Investors should also know that interest and price gains from bonds are taxable income.

• Interest
  Interest on capital assets is subject to the 30 percent interest income tax. The tax is taken directly by the revenue office at the time the profit is paid out. The ultimate tax paid depends on the investor’s personal income tax rate. Currently the tax exempt amount is €1,370 for singles and €2,740 for married couples.
• Price gains
  Profits realized from an increase in a bond’s price are subject to income-tax rates as long as the transaction occurs within one year. At the same time, however, realized losses can be used to offset taxes, but only up to the amount of profit subject to tax in the same year. If the realized profit in the calendar year is less than €512, the profits are not subject to taxation.

Methods for rating bonds

A bond’s valuation depends on the issuer’s creditworthiness, which indicates the issuer’s quality as a debtor. If the issuer fulfills its duties regarding payments of nominal interest and if the probability is great that the bond’s nominal value will be repaid, the issuer has high creditworthiness, as determined by a rating agency. The most well-known are Moody’s and Standard & Poor’s.

The rating is important for developing an investment strategy, because the strategy is predicated on the investor’s willingness to take on risk. Investors that want a high level of security in their investments will want to buy bonds with first-class ratings. Investors who expect market rates to fall will more likely want to invest in long-term zero bonds.

Equities vs. bonds

Shareholders have a ownership stake in a company. They profit from the company’s earnings, which, however, are by no means guaranteed. Bond holders, in contrast, are creditors with a fixed claim to repayment. With long-term investments, it has been shown that stock portfolios deliver higher yields than an investment in bonds.

It makes sense to distribute assets not only across several companies, but also across several types of investment vehicles, such as stocks and bonds. The advantage is that losses from stock investments can potentially be equalized by profits from investments in bonds. The investor’s individual preferences determines in large part the break down between stock and bond investments. Younger investors tend to prefer to buy stocks since they want to realize higher long-term profits. Short-term fluctuations are less relevant to them because of the longer investment timeline. Investors who place value on regular profits are more likely to choose bonds.